Employee vs. independent contractor: the cost of mislabeling

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While many workers are content with job stability and employee benefits, a growing number are becoming independent contractors in favor of working nine-to-fives. Greater flexibility, according to studies, does improve happiness and productivity after all.

Companies also benefit from independent contractors, relying on their short-term help and outside expertise at a fraction of the cost of hiring an employee. However, there are companies that treat independent contractors as though they are employees, which puts the business in legal jeopardy.

According to the Internal Revenue Service (IRS), independent contractors are considered self-employed workers and provide services without the company having extensive control over what the worker does, where the job is done or how it is done.

The greater the amount of control the company exercises, the more likely the independent contractor would legally be considered a common-law employee. In such cases, the company is responsible for withholding and paying certain taxes for the worker.

The pros and cons of being an independent contractor

There are important differences between employees and independent contractors. Employees typically have schedules, fixed paydays and at least some benefits, with the company sharing the burden of employees’ Social Security and Medicare taxes. As an employee, your income is also subject to income tax withholdings.

The drawbacks to working for someone else include an inflexible schedule, having to commute to an office and bosses dictating your daily work.

Independent contractors set their own schedules, but with additional flexibility comes more risk and responsibility. Although you are able to dictate your own work, this regularly requires working longer hours to find clients. Many independent contractors also spend a fair amount of time invoicing clients and awaiting payment. Furthermore, those who are self-employed bear the full employment tax burden and the costs of health insurance.

Despite these responsibilities, independent contractors often prefer freedoms like working with multiple clients at once and working from the comforts of wherever desired.

How companies mislabel employees and independent contractors

Many companies are hiring independent contractors and imposing limits to their independence, while avoiding payroll taxes. They are dictating independent contractors’ schedules, supervising their work and requiring them to work inside the company’s office, basically treating the worker as an employee.

A worker is either an employee or an independent contractor and should be treated accordingly. The IRS is clear: “You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done).”

One common but often illegal practice is a company using independent contractor agreements during a “probationary period,” when the company is able to determine how well they like you before hiring you as an employee. As stated, the greater the extent of the company’s control, the more likely the worker would be considered a common-law employee. A company cannot treat you like an employee while simultaneously avoiding payroll taxes, even if it’s only temporary.

Uber and Lyft are great examples of how independent contractors should work. While these companies set guidelines and rules of conduct for drivers to follow, and also disburse payments to them, drivers are not required to follow a certain schedule or report to anyone. Drivers determine when and where they will provide their services. And since drivers are not employees, they are responsible for paying taxes on this income.

What are the criteria for determining a worker’s appropriate label?

Hiring an independent contractor should be beneficial and fair to all parties, and this is easily accomplished when laws are followed.

“Although a contract may state that the worker is an employee or an independent contractor,” says the IRS, “this is not sufficient to determine the worker’s status.” Fortunately, the government provides the following rules to assess the company’s extent of control and determine the appropriate worker classification:

  • Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  • Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  • Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

The IRS recommends businesses consider all of these factors to determine the correct classification, and can also determine workers’ statuses for the business if it is still unclear.

The cost of mislabeling or misclassifying a worker

If it is determined that an employee is misclassified as an independent contractor, a company can face a number of penalties by both the Department of Labor and the IRS, including being required to pay back-taxes and interest on wages. Misclassified workers may be able to retroactively claim employee benefits as well.

There have also been many class action lawsuits due to the mislabeling of independent contractors, resulting in multimillion-dollar settlements from companies like DoorDash and FedEx. However, some businesses qualify for relief from federal employment tax with reasonable basis defined under the IRS’ Section 530.

Remedies for workers who are mislabeled

If you signed an independent contractor agreement but are being treated like an employee, there are solutions. First, you should speak with the company and explain what you’ve learned about worker classifications. Hopefully, the company will take action to investigate and, depending on their findings, agree to reclassify you and pay applicable taxes.

Second, you can get the IRS involved. Misclassified workers can file Form 8919, Uncollected Social Security and Medicare Tax on Wages, to report the share of uncollected Social Security and Medicare taxes the company should owe. The IRS may contact the business to investigate before arriving at their determination, which can cause tension between you and the company. A third option is to file a complaint with the Dept. of Labor.

Let’s be clear: correctly classifying workers is the employer’s legal responsibility.

Employers who mislabel workers may participate in the Voluntary Classification Settlement Program, allowing you to reclassify workers as employees for future tax periods, “with partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers (or a class or group of workers) as employees.”

Independent contractors are vital to businesses across many industries. With more workers becoming contractors, it is imperative to understand classification. For employers, mislabeling a worker can be costly, legally and financially. As an independent contractors, you have to fight for fairness and your independence, which affects your ability to thrive as a self-employed worker in the long run.

For more information on the rights of independent contractors and employees, visit irs.gov. Please understand that this is not considered legal advice but a discussion of information provided by the IRS.

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